Overview of Risk and Return

1. Chapter 3 Overview of Risk and Return

2. What is Risk? • A risky situation is one which has some probability of loss • The higher the probability of loss, the greater the risk • The riskiness of an investment can be judged by describing the probability distribution of its possible returns

3. Probability Distributions • A probability distribution is simply a listing of the probabilities and their associated outcomes • Probability distributions are often presented graphically as in these examples

4. The Normal Distribution • For many reasons, we usually assume that the underlying distribution of returns is normal • The normal distribution is a bell-shaped curve with finite variance and mean

5. The Expected Value • The expected value of a distribution is the most likely outcome • For the normal dist., the expected value is the same as the arithmetic mean • All other things being equal, we assume that people prefer higher expected returns E(R)

6. Suppose that a particular investment has the following probability distribution: • 25% chance of -5% return • 50% chance of 5% return • 25% chance of 15% return • This investment has an expected return of 5% The Expected Return: An Example

7. The Variance & Standard Deviation • The variance and standard deviation describe the dispersion (spread) of the potential outcomes around the expected value • Greater dispersion generally means greater uncertainty and therefore higher risk

8. Calculating s 2 and s : An Example • Using the same example as for the expected return, we can calculate the variance and standard deviation: • Note: In this example, we know the probabilities. However, often we have only historical data to work with and don’t know the probabilities. In these cases, we assume that each outcome is equally likely so the probabilities for each possible outcome are 1/N or (more commonly) 1/(N-1).

9. The Scale Problem • The variance and standard deviation suffer from a couple of problems • The most tractable of these is the scale problem: • Scale problem - The magnitude of the returns used to calculate the variance impacts the size of the variance possibly giving an incorrect impression of the riskiness of an investment

10. The Scale Problem: an Example Is XYZ really twice as risky as ABC? No!

11. The Coefficient of Variation • The coefficient of variation (CV)provides a scale-free measure of the riskiness of a security • It removes the scaling by dividing the standard deviation by the expected return (risk per unit of return): • In the previous example, the CV for XYZ and ABC are identical, indicating that they have exactly the same degree of riskiness

12. Determining the Required Return • The required rate of return for a particular investment depends on several factors, each of which depends on several other factors (i.e., it is pretty complex!): • The two main factors for any investment are: • The perceived riskiness of the investment • The required returns on alternative investments • An alternative way to look at this is that the required return is the sum of the RFR and a risk premium:

13. The Risk-free Rate of Return • The risk-free rate is the rate of interest that is earned for simply delaying consumption • It is also referred to as the pure time value of money • The risk-free rate is determined by: • The time preferences of individuals for consumption • Relative ease or tightness in money market (supply & demand) • Expected inflation • The long-run growth rate of the economy • Long-run growth of labor force • Long-run growth of hours worked • Long-run growth of productivity

14. The Risk Premium • The risk premium is the return required in excess of the risk-free rate • Theoretically, a risk premium could be assigned to every risk factor, but in practice this is impossible • Therefore, we can say that the risk premium is a function of several major sources of risk: • Business risk • Financial leverage • Liquidity risk • Exchange rate risk

15. The MPT View of Required Returns • Modern portfolio theory assumes that the required return is a function of the RFR, the market risk premium, and an index of systematic risk: This model is known as the Capital Asset Pricing Model (CAPM). It is also the equation for the Security Market Line (SML)

16. Risk and Return Graphically The Market Line Rate of Return RFR Risk b or s

17. Portfolio Risk and Return • A portfolio is a collection of assets (stocks, bonds, cars, houses, diamonds, etc) • It is often convenient to think of a person owning several “portfolios,” but in reality you have only one portfolio (the one that comprises everything you own)

18. Expected Return of a Portfolio • The expected return of a portfolio is a weighted average of the expected returns of its components: • Note: wi is the proportion of the portfolio that is invested in security I, and Ri is the expected return for security I.

19. Portfolio Risk • The standard deviation of a portfolio is not a weighted average of the standard deviations of the individual securities. • The riskiness of a portfolio depends on both the riskiness of the securities, and the way that they move together over time (correlation) • This is because the riskiness of one asset may tend to be canceled by that of another asset

20. The Correlation Coefficient • The correlation coefficient can range from -1.00 to +1.00 and describes how the returns move together through time.

21. The Portfolio Standard Deviation • The portfolio standard deviation can be thought of as a weighted average of the individual standard deviations plus terms that account for the co-movement of returns • For a two-security portfolio:

22. An Example: Perfect Pos. Correlation

23. An Example: Perfect Neg. Correlation

24. An Example: Zero Correlation

25. Interpreting the Examples • In the three previous examples, we calculated the portfolio standard deviation under three alternative correlations. • Here’s the moral: The lower the correlation, the more risk reduction (diversification) you will achieve.